Module: Principles of Cost Accounting

Module code: FBT 06208

Programme: ODA II, ODEF II, ODA IT II & ODFB II

LECTURE 2: INTRODUCTION TO COST TERMS AND CLASSIFICATION OF COSTS

Learning Objectives:

1. Cost concepts

2. Objectives of cost accounting

3. Classification of costs

4. Other classification of costs

5. Costs classified for decision-making

6. Review Questions.

Facilitator: Honory Mkelemi

FCPA (T), MBA Gen. Mgt, ADCA.

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1.0 Cost concepts

1.1 Cost

According to the English dictionary, cost refers to the total expenses incurred
in the production of goods or services by an individual or organization.

Examples of expenses which constitute cost are;

i. Materials
ii. Labour
iii. Factory overheads
iv. Administrative overheads
v. Selling and distribution overheads.

In cost accounting, cost is defined as the amount of expenditure incurred on

or attributable to a product, service, job or process.

Cost must be related to a particular activity or product and expressed for a

given quantity or unit of goods produced or services performed

In simplest terms, cost includes two components (ie: quantity and price) and
expresses as follows;
Cost = quantity used x price

NB:
Cost and loss
There should be a clear distinction between the terms ‘cost’ and ‘loss.’ Cost
usually signifies expenditure incurred for securing some benefit to the
business. If no benefit is derived from a particular expenditure, it is regarded
as a loss. Example; cost of materials destroyed by fire or salary paid to a
foreman during the period of strike is not regarded as cost. These are
examples of loss to the business.

1.2 Cost unit

The term 'cost unit' refers to a unit of product, service or time in relation to
which costs may be ascertained. It is a unit of quantity in terms of which costs
can be measured.
The following are some examples of cost units used in different industries:

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Name of Industry Cost Units used
Paper - Per Tonne (or) Per Kg
Steel - Per Tonne notional
Sugar - Per Quintal
Cement - Per Tonne
Textile (cloth) - Per Metre
Transport - Passenger Kilometre
Electricity - Per Kilo Watt-hour

1.3 Cost center

According to CIMA (Chartered Institute of Cost and Management Accountants),
cost center is defined as part of an organization which includes a location,
person, items of equipment, for which costs may be ascertained and used for
purposes of cost control.

1.4 Total cost

This is the accumulation of production costs in an organization. The cost buildup
is as follows;

Direct Material
Direct Labour Prime cost
Direct Expenses

Indirect Material
Indirect Labour Overheads
Indirect Expenses
Therefore;
Total cost = Prime cost + Overheads

 Prime cost
Is the aggregate (total) of direct materials, direct labour and direct
expenses
Prime cost = Direct Material + Direct Labour + Direct Expenses

 Conversion cost
Is the cost for converting raw materials into finished product.
It is the aggregate (total) of direct labour and overheads.
Conversion cost = Direct Labour + Overheads

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2.0 Objectives of Cost Accounting
The following are the important objectives of Cost Accounting:
i. Ascertainment of cost (cost of products and services).
ii. Determination of selling price (to aid in fixation of selling price).
iii. Cost control and cost reduction.
iv. Ascertainment of profit of each activity.
v. Assisting Management in decision making (to communicate to the
management all information relating to costs and facilitate managerial
decision-making).
vi. Formulating business policy.
vii. Matching costs with revenue.

3.0 Classification of costs

3.1 Introduction
- According to the English dictionary, classification is a systematic
arrangement in groups or categories according to established criteria.

- In simple language, classification is the process of grouping together

items which are similar.

- In cost accounting;
Classification of costs essentially means grouping of costs according to
their similar or common characteristics or features.

3.2 Methods or bases of classifying costs

There are a numerous ways in which costs are classified. The common bases are;
i. Cost on the basis of behavior/ variability.
ii. Cost based on traceability to cost objects (or identifiability to products)
iii. Cost based on their nature (or cost elements)
iv. Cost based on functions (function-wise classification)

4.2.1 Cost on the basis of behavior/ variability.

Costs are classified according to their behavior in relation to changes in output/

production within a given period of time.
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On this basis, costs are classified into;

i) fixed costs, ii) variable costs, and iii) semi-variable (or semi-
fixed) costs
Fixed costs: costs which generally remain fixed/ unchanged/ unaffected by
changes in volume of output or sales. Examples are; rent, insurance,
depreciation on a straight-line basis.
It should however be noted here that fixed costs do not remain fixed all the time.
They remain fixed only up to a certain level of production capacity. If there is a
change in the production capacity, which require additional building and
equipment, such costs will also increase.

Variable costs: costs which change according to volume of production. Examples

are; direct materials, direct labour, direct expenses, sales commission,
consumable stores, etc

In other words, they increase or decrease in direct proportion to changes in the

volume of output.

Semi-variable costs: costs which have the characteristics of both fixed cost and
variable cost
These costs increase or decrease with a change in volume of output but not in
the same proportion as the change in the volume of output. Example;
remuneration (payment) of the salesman; if the quantity of goods sold increases,
the remuneration of the salesman may also increase; but such increase may not
being direct proportion to the increase in sales because his commission on sales
will increase while his salary remains the same.

4.2.2. Cost on the basis of traceability to cost objects (or identifiability to

products)
On this basis, costs are divided into (i) direct costs and (ii) indirect costs

Direct costs: costs that can easily be identified with the final product. Examples;
direct material and direct labour.

Indirect costs: refer to costs that cannot easily be identified to a particular

product. Examples; rent of factory building, salary of production manager/
factory supervisor, depreciation of factory, etc

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 These are known as overheads and can be subdivided into factory, admin, selling
and distribution overheads.

4.2.3 Cost on the basis of nature (or cost elements)

Costs may be classified on the basis nature or cost elements

Based on elements, it is classified into Material Cost, Labour Cost and Other
Expenses. They can be further subdivided into Direct and Indirect Material
Cost, Direct and Indirect Labour Cost and Direct and Indirect Other Expenses.

4.2.4 Cost on the basis of functions (functional classification/ function-wise

classification)
The most common classification of costs in a manufacturing establishment is
on the basis of functions to which they relate.

On this basis costs are classified into four categories;

i. Manufacturing costs
Also known as production costs; these includes cost of material, cost
of labour, other direct expenses and factory overheads.

ii. Administration costs

These are general administrative costs of the organization. Examples;
salaries to office staff, rent of the office building, depreciation and
repairs of office furniture, etc

iii. Selling costs

These are costs which are incurred in connection with the sale of
goods. Examples; cost of warehousing, advertising, salesmen salaries,
commissions etc

iv. Distribution costs

These costs are those costs which are incurred on dispatch of the
finished products to customer including transportation. Examples;
packing, carriage, insurance, freight outwards, etc

4.2.5 Other classifications;

Costs are also classified as follows;

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 i. By Controllability
These are divided into; i) controllable costs and ii) uncontrollable costs
- Controllable costs; these are costs which can be influenced by
management action. Examples

- Uncontrollable costs; these are costs which cannot be controlled or

influenced by management action. Examples

ii. By Normality
These are divided into; i) normal costs and ii) abnormal
costs;

- Normal costs; arise during routine day-to-day business operations.

Examples; cost of fuel to be used by the organization; salary paid to
employees, etc

- Abnormal costs; arise as a result of any abnormal activity/ event which

is not part of routine business operations.

Example; costs arising from floods; accidents; earthquakes, loss in factory

due to fire, etc

iii. By Time
Divided into i) historical cost and ii) predetermined costs;
- Historical costs; are costs incurred in the past and identified with past
events; useful in ascertaining profitability

- Predetermined costs; are estimated future costs.

4.0 Other classification of costs

Further, costs may also be classified according to their relevance to decision-making.

These costs are used for managerial decision making; examples;

i. Relevant costs
ii. Opportunity costs
iii. Differential costs
iv. Marginal costs
v. Replacement costs
vi. Shutdown costs.

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5.0 Review questions:

Question 1
a) Define the following concepts;
i. Cost
ii. Cost unit
iii. Cost center
iv. Total cost

b) Costs are classified in a different number of ways.

Required:
With the help of examples, discuss the classification of cost according to
functions.

Question 2
a) What are the differences between;
i. Controllable costs and uncontrollable costs
ii. Normal costs and abnormal costs

b) Write short notes on the following;

i. Prime cost
ii. Conversion cost
iii. Direct materials
iv. Factory overhead

Question 3
a) What are;
i. Relevant cost
ii. Opportunity cost
iii. Marginal cost
iv. Sunk cost

b) Answer the following questions;

i. Which cost is constant regardless of changes in the level of activity?
ii. What constitutes prime cost?
iii. What constitutes conversion cost?
iv. Which cost is attributable to final products?

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 v. List FIVE important ways in which overheads are classified.
vi. What are mixed costs?
vii. Are future costs relevant costs?
viii. Which of the following can be semi-variable cost;
Telephone charges; vehicle hire charges; basic salaries of employees;
internet usage charges; motor vehicle - repair and maintenance.

Question 4
The following figures relate to Kijiweni Manufacturing Co;
Particulars Amount (Tshs)
Wages 3,000,000
Factory Expenses 4,000,000
Office Expenses 5,000,000
Materials 6,000,000
Selling Expenses 3,000,000
Distribution Expenses 3,000,000
Sales 24,000,000
Output 20,000 units
Number of Units sold 15,000 units

Required:
Compute for Kijiweni Co;
i. Prime cost
ii. Cost of production
iii. Total cost
iv. Cost per unit
v. Profit during the period
vi. Profit per unit.

Question 5
The following are cost and expenditure in a manufacturing company;
i. Wages paid to forklift drivers
ii. Finance director’s salary
iii. Trade discounts given to customers
iv. Depreciation of production machinery
v. Sales advertising
vi. Wages of production workers
vii. Responsibility allowance paid to manager

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 viii. Insurance to company premises
ix. Salary of laboratory scientist
x. Wages of personnel department staff
xi. Repairs and maintenance to machinery
xii. Commission paid to sales representatives.

Required:
Place each expense within the following classification;
- Production
- Selling and Distribution
- Administration
- Research and development.

__________________________________________________________

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(1) On the basis of Nature or Elements: One of the important classification cost is on the basis
of nature or elements. Based on elements, it is classified into Material Cost, Labour Cost and Other
Expenses. They can be further subdivided into Direct and Indirect Material Cost, Direct and
Indirect Labour Cost and Direct and Indirect Other Expenses.

(2) On the basis of Function: The classification of costs on the basis ofthe various function of a
concern is known as function-wise classification. Here there are four important functional
divisions in the business organization, viz.: (a) Production Cost (b) Administration Cost (c) Selling
Cost and (d) Distribution Cost. (3) On the basis of Variability: On the basis of variability with the
volume of production Cost is classified into Fixed Cost, Variable Cost and Semi Variable Cost;
Fixed Costs are those costs incurred which remain constant with the volume of production. Rent
and rates of office and factory buildings are examples of fixed cost.

Variable costs are those costs incurred directly with the volume of output. For example, cost of
materials and wages to workers are the expenses chargeable with direct proportion to the volume
of production. Semi-Variable Costs are those costs incurred, partly fixed and partly variable, with
the volume of production. Accordingly, it has both fixed and variable features. For example,
depreciations and maintenance cost of plant and machinery.

(4) On the basis of Normality:

Costs are classified into normal costs and abnormal costs on the basis of normality features.
Normal costs are those incurred normally within the target output or fixed plan. (5) On the basis
of Controllability and Decision Making: Based on the managerial decision making and
controllability the classifications are as follows: (a) Controllable Cost; (b) Uncontrollable Cost;
(c) Sunk Cost; (d) Opportunity Cost; (e) Replacement Cost; and (0 Conversion Cost. (a)
Controllable Costs: Controllable Costs are the costs

RELEVANT COSTS

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Relevant costs are costs relevant for a specific purpose or situation. In the context of decision
making, only those costs are relevant which are pertinent to the decision making only those costs
are considered. Since we are concerned with future costs only while making a decision, historical
costs, unless they remain unchanged in the future period are irrelevant to the decisionmaking
process

Normal & Abnormal Costs: Normal

cost is a cost that is normally incurred at a given level of output in the conditions in which that
level of output is achieved. Abnormal cost is an unusual a typical cost whose occurrence is usually
irregular and unexpected and due to some abnormal situation of the production.

Avoidable Costs & Unavoidable Costs:

Avoidable costs are those which under given conditions of performance efficiency should not have
been incurred. Costs which are escapable costs and which are not essentially to be incurred, within
the limits or norms provided for. Unavoidable cost are those costs that must be incurred under a
programme of business restriction. It is fixed in nature and inescapable. (j) Uniform Costing: This
is not a distinct system of costing.

Controllable and Uncontrollable Costs:

Controllable cost is that cost which is subject to direct control some level of managerial
supervision. Non-controllable cost is the cost is not subject to control at any level of managerial
supervision. Also controllable costs are the costs, which are influenced by the action of specified
member of an undertaking. Uncontrollable costs are those costs which are not influenced by the
action of specified member of an undertaking.

Controllable Costs: Controllable Costs are the costs which can be influenced by the action of a
specified number of an undertaking. Controllable Costs incurred in a particular responsibility
centre can be influenced by the action of the executive heading that responsibility centre. For
example, direct materials and indirect materials.

Uncontrollable Costs: Uncontrollable Costs are those costs which cannot be influenced by the
action of a specified number of an undertaking. In fact, no cost is controllable, it is only in relation
to a particular individual that may specify a particular cost to either controllable or non-
controllable. For example, rent and rates.

Cost Centre

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According to the Chartered Institute of Management Accountants, London, Cost Centre is defined
as a location, person or items of equipment (or group of these) for which costs may be ascertained
and used for purposes of cost control.

In other words, cost centre is a part of an organization which includes location, processes,
equipment, (or) machine centres, various departments, persons etc. in relation to which costs can
be charged or ascertained. Cost Centres can be classified into the following types :

(1) Personal Cost Centre: It consists of a person or group of persons, e.g., salesmen, Marketing
Manager, etc.

(2) Impersonal Cost Centre: It is a Cost Centre which consists of a location or items of equipment.
(3) Operation Cost Centre: It consists of machines and/or persons carrying out similar operations.
(4) Process Cost Centre: It is a Cost Centre which consists of a specific process or a continuous
sequence of operations.

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